Global Cost and Availability

of Capital

• Global integration of capital markets has given many

firms access to new and cheaper sources of funds
beyond those available in their home markets.
• If a firm is located in a country with illiquid, small,
and/or segmented capital markets, it can achieve this
lower global cost and greater availability of capital by a
properly designed and implemented strategy.
• Exhibit 13.1 illustrates these points.

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 Exhibit 13.1 Dimensions of the Cost and Availability
of Capital Strategy

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 Global Cost and Availability
of Capital
• A firm that must source its long-term debt and equity in a highly
illiquid domestic securities market will probably have a relatively
high cost of capital and will face limited availability of such
capital which will, in turn, damage the overall competitiveness
of the firm.
• Firms resident in industrial countries with small capital markets
may enjoy an improved availability of funds at a lower cost, but
would also benefit from access to highly liquid global markets.

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 Global Cost and Availability
of Capital

• Firms resident in countries with segmented capital

markets must devise a strategy to escape dependence
on that market for their long-term debt and equity
needs.
• A national capital market is segmented if the required
rate of return on securities in that market differs from
the required rate of return on securities of comparable
expected return and risk traded on other securities
markets.

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 Weighted Average Cost of Capital

• A firm normally finds its weighted average cost of capital

(WACC) by combining the cost of equity with the cost of debt in
proportion to the relative weight of each in the firm’s optimal
long-term financial structure:

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 Cost of Equity

• The capital asset pricing model (CAPM) approach is to

define the cost of equity for a firm by the following
formula:

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 Cost of Equity

• The key component of CAPM is beta, the measure of systematic

risk.
• If beta < 1.0 returns are less volatile than the market
• If beta = 1 returns are the same as the market
• If beta > 1.0 returns are more volatile than the market

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 Cost of Debt

• The normal procedure for measuring the cost of debt requires a

forecast of interest rates for the next few years, the proportions
of various classes of debt the firm expects to use, and the
corporate income tax rate.
• The interest costs of different debt components are then
averaged (according to their proportion).
• The before-tax average, kd, is then adjusted for corporate
income taxes by multiplying it by the expression (1- tax rate), to
obtain kd(1 - t), the weighted average after-tax cost of debt.

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 International Portfolio Theory and
Diversification
• The total risk of any portfolio is therefore composed of
systematic risk (the market as measured by beta) and
unsystematic risk (the individual securities).
• Increasing the number of securities in the portfolio reduces the
unsystematic risk component but leaves the systematic risk
component unchanged.
• A fully diversified domestic portfolio would have a beta of 1.0.
• Exhibit 13.2 illustrates the incremental gains of diversifying both
domestically and internationally.

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 Exhibit 13.2 Market Liquidity, Segmentation, and the
Marginal Cost of Capital

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 International Portfolio Theory and
Diversification
• Internationally diversified portfolios are similar to domestic
portfolios because the investor is attempting to combine assets
that are less than perfectly correlated.
• International diversification is different in that when the investor
acquires assets or securities from outside the investor’s host-
country market, the investor may also be acquiring a foreign
currency-denominated asset. Thus, the investor has actually
acquired two additional assets—the currency of denomination
and the asset subsequently purchased with the currency.

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 International CAPM (ICAPM)

• ICAPM assumes the financial markets are global, not

just domestic.
• Our WACC equation adjusts for new opportunities:

• The risk-free rate is unlikely to change much, but beta

easily could change.
• Exhibit 13.3 presents an example for Nestlé

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 Exhibit 13.3 The Cost of Equity for Nestlé of
Switzerland

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 Equity Risk Premiums

• The weighted average cost of capital is normally used

as the risk-adjusted discount rate whenever a firm’s
new projects are in the same general risk class as its
existing projects.
• On the other hand, a project-specific required rate of
return should be used as the discount rate if a new
project differs from existing projects in business or
financial risk.

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 Equity Risk Premiums

• In practice, calculating a firm’s equity risk premium is quite

controversial.
• While the CAPM is widely accepted as the preferred method of
calculating the cost of equity for a firm, there is rising debate
over what numerical values should be used in its application
(especially the equity risk premium).
• This risk premium is the average annual return of the market
expected by investors over and above riskless debt, the term (km
– krf).

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 Equity Risk Premiums

• While the field of finance does agree that a cost of

equity calculation should be forward-looking,
practitioners typically use historical evidence as a basis
for their forward-looking projections.
• The current debate begins with a debate over what
actually happened in the past.
• Arithmetic and geometric average returns provide
different historic risk premiums and they differ across
countries.

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 Equity Risk Premiums

• Different analysts and academics tend to use different

measures for the market risk premium.
• Exhibit 13.4 shows how this can lead to significantly
different results.

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 Exhibit 13.4 Alternative Estimates of Cost of Equity for a
Hypothetical U.S. Firm Assuming β = 1 and krf = 4%

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors

• Gradual deregulation of equity markets during the past three

decades not only elicited increased competition from domestic
players but also opened up markets to foreign competitors.
• To understand the motivation of portfolio investors to purchase
and hold foreign securities requires an understanding of the
principals of:
– portfolio risk reduction;
– portfolio rate of return; and
– foreign currency risk.

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors

• Both domestic and international portfolio managers are asset

allocators whose objective is to maximize a portfolio’s rate of
return for a given level of risk, or to minimize risk for a given rate
of return.
• Since international portfolio managers can choose from a larger
bundle of assets than domestic portfolio managers,
internationally diversified portfolios often have a higher
expected rate of return, and nearly always have a lower level of
portfolio risk since national securities markets are imperfectly
correlated with one another.

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors

• Market liquidity (observed by noting the degree to which a firm

can issue a new security without depressing the existing market
price) can affect a firm’s cost of capital.
• In the domestic case, a firm’s marginal cost of capital will
eventually increase as suppliers of capital become saturated
with the firm’s securities.
• In the multinational case, a firm is able to tap many capital
markets above and beyond what would have been available in a
domestic capital market only.

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors

• Capital market segmentation is caused mainly by:

– government constraints;
– institutional practices; and
– investor perceptions.
• While there are many imperfections that can affect the
efficiency of a national market, these markets can still
be relatively efficient in a national context but
segmented in an international context (recall the
finance definition of efficiency).

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors

• Some capital market imperfections include:

– Asymmetric information
– Lack of transparency
– High transaction costs
– Foreign exchange risks
– Political risks
– Corporate governance issues
– Regulatory barriers

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 The Effect of Market Liquidity and
Segmentation
• The degree to which capital markets are illiquid or segmented has an
important influence on a firm’s marginal cost of capital (and thus on its
weighted average cost of capital).
• The marginal return on capital at different budget levels is denoted as MRR in
Exhibit 13.5.
• If the firm is limited to raising funds in its domestic market, the line MCCD
shows the marginal domestic cost of capital.
• If the firm has additional sources of capital outside the domestic (illiquid)
capital market, the marginal cost of capital shifts right to MCCF.
• If the MNE is located in a capital market that is both illiquid and segmented,
the line MCCU represents the decreased marginal cost of capital if it gains
access to other equity markets.

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 Exhibit 13.5 Market Liquidity, Segmentation, and the
Marginal Cost of Capital

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 The Cost of Capital for MNEs Compared to
Domestic Firms
• Determining whether a MNEs cost of capital is higher or lower
than a domestic counterpart is a function of the:
– marginal cost of capital;
– relative after-tax cost of debt;
– optimal debt ratio; and
– relative cost of equity.
• While the MNE is supposed to have a lower marginal cost of
capital (MCC) than a domestic firm, empirical studies show the
opposite (as a result of the additional risks and complexities
associated with foreign operations).

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 The Cost of Capital for MNEs Compared to
Domestic Firms
• This relationship lies in the link between the cost of capital, its availability,
and the opportunity set of projects.
• As the opportunity set of projects increases, the firm will eventually need to
increase its capital budget to the point where its marginal cost of capital is
increasing.
• The optimal capital budget would still be at the point where the rising
marginal cost of capital equals the declining rate of return on the opportunity
set of projects.
• This would be at a higher weighted average cost of capital than would have
occurred for a lower level of the optimal capital budget.

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 Exhibit 13.6 The Cost of Capital
for MNE and Domestic Counterpart Compared

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 The Cost of Capital for MNEs Compared to
Domestic Firms

• In conclusion, if both MNEs and domestic firms do

actually limit their capital budgets to what can be
financed without increasing their MCC, then the
empirical findings that MNEs have higher WACC stands.
• If the domestic firm has such good growth
opportunities that it chooses to undertake growth
despite an increasing marginal cost of capital, then the
MNE would have a lower WACC.

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 Exhibit 13.7 Do MNEs Have a Higher or Lower Cost of Capital
Than Their Domestic Counterparts?

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